What investments beyond GICs protect buying power?

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By Julie Cazzin with Emily Wheeler

Q: I’m a retiree who has more than half her investments in guaranteed investment certificates (GICs). The higher rates have given me good returns of up to 5.5 per cent annually and I have used the extra money to supplement my modest income. But my GICs come due in January and I can see the writing on the wall. Their returns will dramatically drop as interest rates continue their downward descent. I am considering buying a fixed-income bond fund. Can you tell me a bit about them? — Anita

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FP Answers

Nothing lasts forever, Anita, and that includes rising inflation. Now, after a couple of years of ever-rising interest rates to tamp down inflation, headline inflation is easing. Canada’s annual inflation rate slowed to two per cent in August, and further interest rate cuts are expected by the Bank of Canada this fall. This is good news since decreasing interest rates are supportive of bond prices in general.

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The changing interest rate regime should cheer small-business owners, homebuyers and many investors. However, there is a fly in the ointment for GIC investors: the tide is turning on those risk-free GIC rates that reached as high as six per cent not long ago.

Unlike bonds, whose prices rise when interest rates fall, GICs do not benefit from falling rates. Over the past 42 years, the FTSE Canada Universe Bond Index has outperformed GICs in all but seven years. This is because yield alone does not equal the total return when evaluating the performance of bond funds.

Anita, in this new interest rate environment, does leaning heavily into GICs still make sense? Is it time to reconsider the many advantages of bonds over GICs for achieving better overall returns?

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As its name implies, a GIC guarantees the full return of the initial deposit plus accrued interest. GICs are insured by the Canadian Deposit Insurance Corp. (CDIC) for up to $100,000 per financial institution where they are purchased. For example, you could buy five GICs, each for a face value of $100,000 at five different financial institutions, and, in total, they would be covered for up to $500,000. So far, so good.

Dig a little deeper, however, and there are four major drawbacks to over-relying on exclusively using GICs for generating income over the long term.

Low liquidity

Typically, the longer the term, the better the interest rate on a GIC. During this lock-up period, you cannot easily access your money without foregoing interest earned. Cashing in a term GIC before maturity in this case may incur a significant penalty. This is a drawback should you need the funds prior to the maturity date or want to take advantage of a better investment opportunity.

A hefty allocation to GICs could, therefore, severely limit financial flexibility. By comparison, most bond funds, whether mutual funds or exchange-traded funds (ETFs), are liquid. In the case of a daily valued mutual fund, the fund units can be sold and the proceeds deposited in your account within a day or two.

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Lower total return potential

Compared to other conservative investments, such as government and investment-grade bonds, the return on GICs is based solely on interest. Bonds, on the other hand, offer greater return potential over the long term because their total return is the sum of the interest rate (coupon) and any capital gains.

Bond yield refers to the total return on a bond: coupon payments plus potential capital appreciation, which has the potential to exceed yield depending on price movement over a given period.

The one-year total return difference in a decreasing interest rate environment can be significant. For example, a three-year, high-quality bond with a five per cent coupon and a current price of $99.8 would experience a one-year total return of approximately 7.7 per cent for just a one per cent decrease in rates. That’s significantly better than the one-year GIC rate of about four per cent.

The difference is even starker with a seven-year bond. In this case, a high-quality issuer with a seven-year, five per cent coupon bond priced at $100.29 today would realize an approximately 11 per cent one-year total return (coupon and price appreciation) for the same one per cent decrease in rates.

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The lower total return potential of GICs versus bonds is, therefore, more pronounced in a decreasing interest rate environment.

Lower tax efficiency

Interest income is taxed at an individual’s full marginal tax rate in non-registered accounts, which can add up to double the rate on capital gains. A bond’s total return is a combination of interest and capital gains, the latter of which are taxed more favourably, making bonds a more tax-efficient option in non-registered accounts.

Higher reinvestment risk

GIC rates are more immediately influenced by Bank of Canada interest rate decisions than are bond coupons. As interest rates fall — as they are now — the offered rates for a GIC that comes up for renewal are lower.

Bonds, especially from corporate issuers, can be more dependent on the credit worthiness of the underlying business. They may offer attractive risk/reward characteristics with competitive yields along with the potential for capital appreciation.

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As ever, maintaining a sensibly diversified portfolio offers investors the option to potentially smooth volatility, protect buying power, defend capital against unforeseen events and take advantage of attractive market opportunities. Bonds have earned their place as a sensible diversifier of returns over the long term.

Emily Wheeler is a portfolio manager for the Pender Corporate Bond Fund and the Pender Bond Universe Fund. She holds a Bachelor of Arts degree from the University of British Columbia, obtained her Chartered Financial Analyst (CFA) designation in 2010 and is a CFA Charterholder and a member of CFA Society Vancouver.

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